Net Operating Loss Carryback or Carryforward: What Is Best to Reduce Income Tax Liability?

There are a lot of strategies that contractors can use to reduce their income tax liability. One option is to take a net operating loss (NOL) carryback or carryforward. The decision to take a carryback or carryforward depends on profits, tax rates and timing. If profits and tax rates are expected to be higher in future years, it might be better to use the deduction later.

Treatment of NOLs Under Certain Laws

Prior to the Tax Cuts and Job Act (TCJA) of 2017, contractors could carryback NOLs from a current taxable year to the two preceding taxable years. NOLs could also be carried forward for up to 20 years. Contractors could use 100% of the NOL to offset income on taxes that have already been paid or would be paid in future years.

A provision of TCJA eliminated a taxpayer’s ability to carryback NOLs (except for farm losses). TCJA also eliminated the 20-year limitation on NOL carryforwards so they could be taken indefinitely. However, NOLs can only offset 80% of the amount of taxable income beginning in 2018. Even though TCJA changed how NOLs could be used, losses incurred before 2018 are still governed by the old law.

The Coronavirus Aid, Relief and Economic Security Act (CARES Act) temporarily suspended TCJA NOL provisions for taxable years beginning before Jan. 1, 2021. NOLs incurred in 2018, 2019 and 2020 can be carried back five years and are not subject to the 80% limitation.

Because the tax treatment of NOLs varies, it is important to keep accurate records. NOLs should be categorized by the year of the loss and indicate which law is applicable.

Definition of an NOL

For income tax purposes, a NOL occurs when a company's allowable deductions exceed its taxable income within a tax period. A NOL year is the year in which the NOL occurs.

NOL carryforwards are recorded as an asset on the company's general ledger. They offer a benefit to the company in the form of future tax liability savings. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year until the balance is exhausted. If the NOL is more than the taxable income of the year it is carried to (before deducting the NOL), there will generally be an NOL carryover to the next year, according to Investopedia.

How to Calculate Net Operating Loss

IRS rules limit what can be deducted when calculating NOLs. In general, the IRS does not allow:

• Capital losses in excess of capital gains;
• The section 1202 exclusion of the gain from the sale or exchange of qualified small business stock;
• Nonbusiness deductions in excess of non-business income;
• The NOL deduction; or
• The section 199A deduction for qualified business income.

Limitations Due to a Change in Ownership

The IRS restricts using an acquired company for its NOL’s tax benefits. If a company with a NOL has at least a 50% ownership change, the acquiring company may use only part of the NOL in each concurrent year. However, purchasing a business with a substantial NOL may mean a larger sum of money going to the acquired company’s shareholders than if the acquired company possessed a smaller NOL.

Accounting for NOL Carryforwards

NOL carryforwards are recorded as an asset on the company's general ledger. A deferred tax asset is created for the NOL carryforward, which is offset against net income in future years. The deferred tax asset account is drawn down each year, not to exceed 80% of net income in any one of the subsequent years, until the balance is exhausted.

President Joe Biden has stated that he intends to raise income taxes. Therefore, it is important to determine if it is more advantageous to take a carryback and refund in a year with a lower tax rate or have the NOL available for future years when income tax rates are expected to be higher. Evaluate current working capital needs along with the company’s long-term financial stability before deciding on a course of action. It may be better to wait.